Others Present

Financial Markets

Conditions in financial markets over the past month were dominated by the situation
in Europe, which had deteriorated markedly. The focus was initially on Ireland
but it subsequently spread to Portugal, Spain, Italy and Belgium. Bond spreads
in those countries widened to their highest levels since the inception of the
euro.

Members were briefed on the support package for Ireland from the European Union and
the IMF. A significant part of the package was earmarked to support the Irish
banking system, which is very large relative to the size of the economy. Members
discussed the causes of the current situation in Ireland, which included a
leveraged residential and commercial property boom, and the very rapid growth
in the Irish banking sector. Among other risks, they noted that the Irish banking
system had become highly dependent on borrowing from the European Central Bank
(ECB).

The contagion from Ireland that had spread to other parts of Europe reflected the
financial inter-linkages in the form of interbank exposures, as well as the
European sovereign debt holdings of the European banking system. Credit spreads
in interbank funding markets had increased to their levels around the time
of the Greek crisis in May, though they were still well below the peaks at
the time of the collapse of Lehman Brothers. Members noted that the cost of
funding the large US dollar asset positions held by European banks had also
been rising.

Bond purchases by the ECB had resulted in euro area spreads declining in the days
prior to the Board meeting, although some markets were very illiquid. Notwithstanding
this decline, members noted that the level of bond yields in several peripheral
euro area countries remained high relative to expected growth rates of nominal
GDP.

Credit spreads outside Europe had not been particularly affected and bond issuance
in the United States had continued apace, particularly for non-financial companies.
Spreads on highly rated corporate bonds in the United States had been steady
in recent months, while spreads on lower-rated bonds had narrowed.

Activity in the domestic securitisation market picked up during the month, including
a large issue without support from the Australian Office of Financial Management.

Members noted the US Federal Reserve's decision to ease policy through further
large-scale asset purchases. Speeches by FOMC members subsequent to the Fed's
decision and better-than-expected US data had seen the market pare back its
expectations of further policy measures by the Fed. This had contributed to
a rise in government bond yields in the major markets over the past month.
Financial market volatility had picked up as liquidity declined towards the
end of the year. Illustrating the diverse economic fortunes at present, members
noted that the authorities in China, India, South Korea and Thailand all tightened
policy over the month.

Global equity prices had recovered to around the peak reached in April, but prices
of financial stocks remained well below that level. Chinese equity prices had
fallen as concerns grew about the prospect of further policy tightening in
China.

In foreign exchange markets, the initial reaction to the Fed's policy announcement
early in November was some further depreciation of the US dollar, but more
recently the US dollar had experienced sharp moves in both directions. The
euro had depreciated significantly against the US dollar over the past month.
In the early part of November, the Australian dollar reached a new post-float
high against the US dollar. Since then, reflecting the decline in risk appetite,
the Australian dollar had depreciated against the US dollar, but it had appreciated
against the euro to a new high. On a trade-weighted basis, the Australian dollar
was around 2 per cent higher over the past month.

Members noted that mortgage rates had increased by more than the increase in the
cash rate following the November meeting, such that mortgage rates were now
slightly above their average since 1996. Currently, the market did not expect
any change in monetary policy for the next few months.

International Economic Conditions

Members discussed how the financial turmoil in Europe could affect economic growth
in that region. They noted that, for the euro area as a whole, the economic
data continued to suggest moderate growth, though the differences across countries
were large. Germany continued to outperform, with consumer and business confidence,
and conditions in the labour market, considerably stronger than in the other
European economies.

In China, attention was increasingly turning to the upside risks to inflation. Over
the past year, the CPI was up by 4½ per cent, with food prices up by
around 10 per cent. The authorities had responded by increasing the reserve
requirements on banks and had announced a number of administrative measures
to control price increases, but real interest rates remained low. The recent
economic data continued to show robust growth in industrial production, investment
and consumption, and there were some signs that merchandise exports were increasing
again, after having fallen in earlier months.

Elsewhere in east Asia, the recent data had been mixed. The Japanese economy had
recorded robust growth in the September quarter, though this was mainly driven
by stimulus measures that had changed the timing of expenditure. More recent
data in Japan had been quite soft, with most monthly indicators showing weakness
in October. A number of other economies in the region had recorded declines
in GDP in the September quarter, after large increases over the previous year.
Industrial production and exports had been weak in the quarter, though the
trade data for October suggested a significant pick-up in exports. Domestic
demand looked to be growing solidly in most economies in the region.

Growth in the Indian economy remained strong, with GDP increasing by 10½ per
cent over the year to the September quarter. Growth had been broad-based across
sectors, with agriculture, manufacturing and services all expanding strongly
over the year.

In the United States, the recent data had, on balance, been a little better than
in earlier months. Most of the data for the labour market had suggested some
improvement, though overall jobs growth in November had fallen short of expectations.
Members observed that recent indicators of business investment, business conditions
and household spending suggested that the economy was continuing to expand,
albeit at a modest pace. The recent indicators for the housing sector, however,
showed few signs of improvement. The household saving rate was well above the
levels of the middle of the decade.

Reflecting the increased uncertainties about the global economy, base metals prices
were lower over recent weeks. In contrast, the price of gold had risen. There
had also been significant increases in the spot prices of the steel-making
commodities, namely iron ore and coking coal, which were around 25 per
cent and 10 per cent respectively above the December quarter contract prices,
pointing to increases in contract prices for the March quarter. This was a
stronger outcome than the staff had been expecting, and suggested upside risks
to forecasts for the terms of trade and nominal income. The severity of the
impact of the recent heavy rains in Queensland on coal production remained
to be seen.

Domestic Economic Conditions

In the recent national accounts, GDP was estimated to have increased by 0.2 per cent
in the September quarter and by 2.7 per cent over the year. Nominal GDP was
up by 1.2 per cent in the quarter and 9.6 per cent over the year, boosted by
the rising terms of trade, which had reached a new peak in the September quarter.
Indeed, over the past decade, a significant part of the growth in real incomes
had come from the terms of trade, with growth in standard productivity measures
having slowed significantly relative to the 1990s.

The quarterly GDP outcome was a little softer than had been expected at the time
of the November Statement on Monetary Policy. While the pick-up in business
investment was proceeding in line with the forecasts, consumption growth had
been weaker, as had dwelling investment. Overall, the expected rebalancing
of growth from public to private demand looked to be occurring, though public
demand remained strong. The accounts confirmed that conditions varied considerably
across sectors, with manufacturing output having been flat over the first three
quarters of 2010, in contrast to solid rises in output in the mining sector
and of some professional services.

Other information received since the November meeting had been consistent with a
strengthening in investment. Capital expenditure in the resources sector was
estimated to have increased strongly in the September quarter, and investment
intentions for 2010/11 continued to be very high. Members noted that there
had also been further announcements confirming that several large resources
projects were moving ahead. In contrast, outside the resources sector capital
expenditure was broadly flat in the September quarter, and the outlook was
considerably more subdued than for resources. There were still few signs that
commercial construction was picking up. Business credit had fallen again in
October, though broader measures of financing had been unchanged, and there
was further tentative evidence that the availability of bank financing was
easing for borrowers outside of the commercial property sector.

Spending and borrowing by the household sector remained subdued, with substantially
revised estimates suggesting that the saving rate had returned to its level
of the mid 1980s. While the Bank's liaison continued to suggest modest
growth, there was a surprisingly large fall in the ABS estimate of retail spending
in October. Retailers continued to report that households were cautious in
their spending and significant discounting remained widespread. Measures of
consumer confidence had fallen somewhat after the increases in interest rates
in early November, though confidence was still at an above-average level. Members
observed that the restraint being shown by households, and the pick-up in the
saving rate, would help reduce the medium-term risk from household balance
sheets after a long period when debt ratios had risen, and would help to make
room for the expected increase in investment.

Household credit had grown at only a modest pace for several months. The established
housing market had cooled, with house prices tracking broadly sideways since
June. Auction clearance rates had recently fallen noticeably. In terms of housing
construction, there was an increase in building approvals in October, following
declines over previous months, though the rate of construction was still low.

In the labour market, conditions remained firm. Employment was estimated to have
increased by a further 30,000 in October, and the participation rate had risen
to its highest level on record, with the unemployment rate increasing to 5.4
per cent. Members discussed developments in the participation rate, including
the upward trend in participation by workers in the 45–54 and over-55
year age groups. Employment intentions generally remained solid.

The wage price index for the September quarter confirmed that wage growth in the
economy had picked up from the slow pace of last year. The outcome in the quarter
had been boosted by the earlier decision on minimum wages; abstracting from
this, wages looked to be growing at around their average pace over the past
decade. Members noted that some pick-up in wage growth was likely in the period
ahead. Nonetheless, overall price pressures remained relatively modest at present,
reflecting discounting activity and exchange rate effects, and measures of
inflation expectations remained consistent with the medium-term inflation target.
Members discussed the outcome of the CPI review by the ABS.

Considerations for Monetary Policy

Members noted that the deterioration in the situation in Europe over the past month
had increased the downside risks to the global economy. How this would ultimately
play out, and the implications for Australia, were difficult to predict. It
was possible that conditions could settle down, as they had after the episode
of financial instability in May. Alternatively, an escalation of the current
problems was not out of the question. If this prompted a fresh retreat from
risk-taking in global financial markets, it would probably have more impact
on Australia than any trade effect.

Developments in other parts of the world had been more positive. The US economy was
growing at a modest pace. Recent data suggested that the Chinese and Indian
economies were growing more strongly than expected, and prices for bulk commodities
had strengthened over the past month.

Domestically, the Board's assessment of the central medium-term scenario was
little changed from that made at earlier meetings. Employment growth remained
strong and the expected pick-up in private investment looked to be broadly
on track. Household consumption and borrowing, however, remained restrained
despite high levels of confidence, and the saving rate had increased noticeably
over the past few years. This restraint, if it continued, would provide some
scope for investment to rise without causing aggregate demand to grow too quickly
and inflationary pressures to build.

Following the Board's decision in November to lift the cash rate and the subsequent
increases in lending rates, and taking into account the level of the exchange
rate, monetary policy was judged to be mildly restrictive. Given the very high
level of the terms of trade and the positive outlook for business investment,
this policy setting was regarded as appropriate.